On December 1, 2017, the Commodity Futures Trading Commission announced its agreement to allow CBOE Global Markets, Inc. and CME Group, Inc. to list bitcoin futures contracts on their exchanges. The futures contracts, the first to be listed on traditional U.S. regulated exchanges, are expected to start trading in December 2017. These futures would seemingly allow Regulated Investment Companies (RICs) to satisfy some of the custody concerns of investing in virtual currencies such as bitcoin, also known as cryptocurrencies, but creates tax-related concerns should RICs seek to invest in these contracts.

RICs routinely invest in futures and other derivative contracts. Among other qualification requirements, a RIC must derive at least 90% of its gross income from its business of investing in stock or securities, as defined under the Investment Company Act of 1940, foreign currencies or other income (including gains from options, futures or forward contracts) related to its business of investing in securities and currencies. The tax guidance generally requires a RIC to look at the nature of the underlying assets of a derivative for purposes of the qualifying income test. Accordingly, a RIC would generally look at an investment in a cryptocurrency contract as a direct investment in the cryptocurrency itself for purposes of the qualifying income test.

The IRS has provided some limited guidance on the tax treatment of cryptocurrency investments via Notice 2014-21. Under this notice, the IRS states its position that a cryptocurrency is treated as property and not a currency as defined under tax law. In addition, absent further guidance from the IRS, it is unclear whether cryptocurrencies should qualify as a security under the 1940 Act. Therefore, it appears that the gains from the sale of an investment in crytpocurrencies, or futures contracts on cryptocurrencies, do not seem to meet the definition of qualifying income for this test. Similarly, investments in grantor trust investments holding cryptocurrencies may also create nonqualifying income to a RIC.

Managers of RICs who seek to make cryptocurrency investments should consult legal counsel related to their ability to make such investments under their prospectus and other legal considerations. To the extent allowed, a RIC may consider making cryptocurrency investments through a blocker corporation such as a Controlled Foreign Corporation (CFC). Consideration should be given to certain RIC diversification requirements that would limit a RIC’s investment in controlled entities to 25% of its assets. In addition, a RIC should consider Proposed Regulation Section 1.851-2, released in September 2016, which requires a RIC to treat income from a CFC as qualified income only to the extent of distributions made by the CFC.

The listing of bitcoin futures on the CME and CBOE may present an opportunity for RICs to gain exposure to cryptocurrencies; however, careful consideration and proper planning should be given to the tax and legal ramifications of the investment before the investment is made.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.